Day Trader: Definition, Techniques, Strategies, and Risks

What Is a Day Trader?

A day trader is a type of trader who executes a relatively large volume of short and long trades to capitalize on intraday market price action. The goal is to profit from very short-term price movements. Day traders can also use leverage to amplify returns, which can also amplify losses.

While many strategies are employed by day traders, the price action sought after is a result of temporary supply and demand inefficiencies caused due to purchases and sales of the asset. Typically positions are held from periods of milliseconds to hours and are generally closed out before the end of the day so that no risk is held after hours or overnight.

Understanding Day Traders

There is no special qualification required to become a day trader. Instead, day traders are classified based on the frequency of their trading. The Financial Industry Regulatory Authority (FINRA) and U.S. Securities and Exchange Commission classify day traders based on whether they trade four or more times during a five-day span, provided the number of day trades is more than 6% of the customer's total trading activity during that period or the brokerage/investment firm where they have opened an account considers them a day trader.

A day trader often closes all trades before the end of the trading day, so as not to hold open positions overnight. A day trader's effectiveness may be limited by the bid-ask spread, trading commissions, as well as expenses for real-time news feeds and analytics software. Successful day trading requires extensive knowledge and experience. Day traders employ a variety of methods to make trading decisions. Some traders employ computer trading models that use technical analysis to calculate favorable probabilities, while some trade on their instinct.

A day trader is primarily concerned with the price action characteristics of a stock. This is unlike investors, who use fundamental data to analyze the long-term growth potential of a company to decide whether to buy, sell or hold its stock.

Price volatility and average day range are critical to a day trader. A security must have sufficient price movement for a day trader to achieve a profit. Volume and liquidity are also crucial because entering and exiting trades quickly is vital to capturing small profits per trade. Securities with a small daily range or light daily volume would not be of interest to a day trader.

Pattern Day Trader Designation

A pattern day trader (PDT) is a regulatory designation for those traders or investors that execute four or more day trades over the span of five business days using a margin account.

The number of day trades must constitute more than 6% of the margin account's total trade activity during that five-day window. If this occurs, the trader's account will be flagged as a PDT by their broker. The PDT designation places certain restrictions on further trading; this designation is put in place to discourage investors from trading excessively.

Day Trader Techniques

Day traders are attuned to events that cause short-term market moves. Trading the news is a popular technique. Scheduled announcements such as economic statistics, corporate earnings, or interest rates are subject to market expectations and market psychology. Markets react when those expectations are not met or are exceeded, usually with sudden, significant moves, which can benefit day traders.

Another trading method is known as fading the gap at the open. When the opening price shows a gap from the previous day’s close, taking a position in the opposite direction of the gap is known as fading the gap. For days when there is no news or there are no gaps, early in the morning, day traders will take a view on the general direction of the market.

If they expect the market to move up, they would buy securities that exhibit strength when their prices dip. If the market is trending down, they would short securities that exhibit weakness when their prices bounce.

Most independent day traders have short days, working two to five hours per day. Often they will practice making simulated trades for several months before beginning to make live trades. They track their successes and failures versus the market, aiming to learn by experience.

Day Trader Strategies

Day traders use several intraday strategies. These may include:

• Scalping: this strategy attempts to make numerous small profits on small price changes throughout the day, and may also include identifying short-lived arbitrage opportunities.
• Range trading: this strategy primarily uses support and resistance levels to determine buy and sell decisions. This trading style may also go by the name swing trading if positions are held for weeks rather than hours or days.
• News-based trading: this strategy typically seizes trading opportunities from the heightened volatility around news events and headlines.
• High-frequency trading (HFT): these strategies use sophisticated algorithms to exploit small or short-term market inefficiencies up to several thousand times in a single day.

Advantages and Disadvantages of Day Trading

No Overnight Moves

The most significant benefit of day trading is that positions are not affected by the possibility of negative overnight news that has the potential to impact the price of securities materially. Such news includes vital economic and earnings reports, as well as broker upgrades and downgrades that occur either before the market opens or after the market closes.

Higher Margins and Easier Exits

Another advantage is the ability to use tight stop-loss orders—the act of raising a stop price to minimize losses from a long position. Another includes the increased access to margin—and hence, greater leverage. Day trading also provides traders with more learning opportunities. 

Higher Costs

Intraday traders may have insufficient time for a position to see a profit. There are also increased commission costs due to trading more frequently, which eats away at the profit margins a trader can expect.

Higher Risks

Day traders that engage in short selling or use margin to leverage long positions can see losses amplify quickly, leading to margin calls.

Example of Day Trading

Zack is a day trader who uses technical analysis to make trades with his brokerage account. By analyzing price trends over a single day, he is able to predict short-term movements to score a small profit several times per day.

During a typical trading day, Zack will watch metrics such as the Relative Strength Index and the Intraday Momentum Index to evaluate whether a particular stock is oversold or undersold. He may also use margin trading to increase his profits. He may also use stop-loss orders to exit positions quickly if the market turns against him.

If Zack is a successful day trader, then he expects to have more profitable trades than losing ones over the course of the day. However, one bad trade could wipe out his margin position. Due to this risk, day trading is sometimes compared to "picking up pennies in front of a steamroller."

Day Trading vs. Other Types of Trading

Day trading is one of several strategies for professional stock traders. Unlike other traders, they look for predictable price patterns and small corrections over the course of a single trading day. Although the profits are relatively small, they can accumulate over a long-enough time frame. Day traders typically close out their positions at the end of the trading day, reducing their exposure to swings in the overseas markets.

In contrast, swing traders try to anticipate the peaks and troughs of a stock's price movements over a longer time frame, often weeks or months. With the right strategy, swing traders can earn higher profits than intraday traders, but they have to spend more time looking for suitable stocks.

Similar to swing traders, trend traders examine a stock's momentum and moving averages to determine whether a stock is likely to move higher or lower. They then buy stocks with a strong upside, or short those likely to trend lower. Trend traders are likely to look for chart patterns or technical indicators in their forecasts.

How to Become a Day Trader

Becoming a successful day trader requires a great deal of personal discipline. Novice day traders should expect to lose money as they learn the ins and outs of the market and be psychologically prepared for further losses over the course of their careers.

Day trading also involves a great deal of research, not only into the fees and commissions on their trades but also the relevant taxes and regulations. For example, day traders should be cognizant of the wash sale rule, which prohibits repeated transactions of the same security within a 30-day period. They should also fully understand the risks, especially of trading on margin.

The Bottom Line

Day traders look for extremely short-term price changes in the stock or forex market, allowing them to accumulate profits over the course of a trading day. Although it can be profitable, it also comes with a high degree of risk—especially for traders on margin positions. In addition to a thorough understanding of the stock market, day traders must also exercise self-control and avoid impulsive mistakes.